Fed fights inflation today -- but tomorrow?

By Jim Jubak

Like the rest of us, the people who will fill the chairs at the Aug. 8 meeting of the Federal Reserve are gazing with horror at the pictures of victims being pulled out of rubble in Israel and Lebanon. Like the rest of us, they wonder if the daily hail of rockets and bombs will turn into a wider regional war. And, like the rest of us, they read about the plans of the world's leaders to end this latest war in the Middle East with a mixture of hope and cynicism.

But as bankers, Fed Chairman Ben Bernanke and the other members of the Federal Reserve's Open Market Committee aren't supposed to react the way that we do. They're supposed to see this carnage through the lens of just one question: Will this war have any significant effect on the U.S. economy?

In the short run, I think the unemotional, factual answer to that question is no. As Bernanke made clear in his semiannual monetary report to Congress on July 19, the Federal Reserve doesn't believe that the violence in the Middle East will affect the U.S. economy or the rate of inflation enough to change the Federal Reserve's mind about its next interest-rate increase. At the beginning of the week, the Fed funds futures market was predicting a 70% chance that the Federal Reserve would raise interest rates for the 18th time to a target short-term rate of 5.5%. (Just before chairman Bernanke's July 19 speech, odds of a rate hike had climbed to 90%; after the speech, they fell to 64%. That's a typical Wall Street swing between too much fear and too much hope. The initial 70% projection seems about right to me.)

In the long run, however, even if the bankers at the Federal Reserve can put all their emotions on the shelf, they still know that the world is a more uncertain place than it was before war broke out. The bankers know that uncertainty can freeze an economy in its tracks. That heightens the risk that the economy could slow more than the Federal Reserve desires.

I think the chaos in the Middle East raises the odds that an Aug. 8 interest-rate hike will be the last for the Federal Reserve in this cycle of tightening. Certainly, the Fed funds futures market now believes that the Fed will be done after August: The Fed funds futures are now priced for a slight decline in short-term interest rates by the end of 2006.

But there are other factors more important than the so-far limited war in the Middle East that are pushing the Federal Reserve toward an August rate hike: data on economic growth in China, inflation at the producer price and consumer level, and projected economic growth in the third and fourth quarters of 2006.

China's growing too fast -- and that's inflationary

Officially, China grew by 10.3% in the first quarter of 2006. That's about par for the course for this extraordinary economy that officially grew 9.9% in 2005, 10.1% in 2004 and 10% in 2003.

But then, for the second quarter, China's economy actually accelerated, beating even its own extraordinary record, by posting an 11.3% growth rate. See what I mean? That's embarrassingly high for a government that is trying just about everything it can to prevent runaway growth that in the longer run would lead to raging inflation, massive misallocation of capital, and eventually a recession as supply overwhelmed demand. In public statements, Chinese officials called investment in fixed assets "excessive." Fixed-asset investment increased by 30% in the first half of the year and in those six months banks made loans equal to 87% of the annual loan target set by the central bank.

Officials at China's central bank aren't the only ones viewing these numbers with concern. Any acceleration in Chinese economic growth will push prices for commodities higher around the world. Some economists, such as those at Dresdner Kleinwort Wasserstein, based in London and Frankfurt, are predicting even faster growth in 2007 than in 2005, and you can count the Fed among the worrywarts. As Bernanke put it in his July 19 testimony to Congress, "Together with heightened geopolitical uncertainties and the limited ability of suppliers to expand capacity in the short run, these rising demands have resulted in sharp rises in the prices at which those goods (crude oil and other primary commodities) are traded internationally, which in turn has put upward pressure on costs and prices in the United States."

Worries about inflation

Looking backward, the inflation numbers in the United States don't look good.

Inflation as measured by the Producer Price Index, an index of prices at the wholesale level and often a good predictor of the direction of consumer prices, came in above expectations for June but below the levels of 2005 that had so worried the Federal Reserve. Reported on July 18, the monthly increase for June was 0.5%, way above the 0.3% expected. The annualized growth in inflation at the wholesale level was a high 4.9%, but still down from the 6.9% reported in September 2005 -- the highest level in the last 15 years. The core Producer Price Index, which subtracts volatile energy and food prices, came in exactly on expectations at 0.2% for the month. The annualized rate fell to 1.5% from the 10-year high of 2.8%, hit in July 2005.

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